ETFs offer several advantages over conventional mutual funds. First, as we just noted, a mutual fund’s net asset value is quoted—and therefore, investors can buy or sell their shares in the fund—only once a day. In contrast, ETFs trade continuously. Moreover, like other shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.
ETFs also offer a potential tax advantage over mutual funds. When large numbers of mutual fund investors redeem their shares, the fund must sell securities to meet the redemptions. This can trigger capital gains taxes, which are passed through to and must be paid by the remaining shareholders. In contrast, when small investors wish to redeem their position in an ETF they simply sell their shares to other traders, with no need for the fund to sell any of the underlying portfolio. Moreover, when large traders wish to redeem their position in the ETF, redemptions are satisfied with shares of stock in the underlying portfolio. Again, a redemption does not trigger a stock sale by the fund sponsor.
The ability of large investors to redeem ETFs for a portfolio of stocks comprising the index, or to exchange a portfolio of stocks for shares in the corresponding ETF, ensures that the price of an ETF cannot depart significantly from the NAV of that portfolio. Any meaningful discrepancy would offer arbitrage trading opportunities for these large traders, which would quickly eliminate the disparity.
ETFs are also cheaper than mutual funds. Investors who buy ETFs do so through brokers, rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses translates into lower management fees. For example, Barclays charges annual expenses of just over 9 basis points (i.e., .09%) of NAV per year on its S&P 500 ETF, whereas Vanguard charges 18 basis points on its S&P 500 index mutual fund.
There are some disadvantages to ETFs, however. Because they trade as securities, there is the possibility that their prices can depart by small amounts from NAV. As noted, this discrepancy cannot be too large without giving rise to arbitrage opportunities for large traders, but even small discrepancies can easily swamp the cost advantage of ETFs over mutual funds.
Second, while mutual funds can be bought for NAV with no expense from no-load funds, ETFs must be purchased from brokers for a fee. Investors also incur a bid–ask spread when purchasing an ETF. ETFs have to date been a huge success. Most trade on the Amex and currently account for about half of Amex trading volume. So far, ETFs have been limited to index portfolios.
A variant on large exchange-traded funds in a “built-to-order” fund, marketed by sponsors to retail investors as folios, e-baskets, or personal funds. The sponsor establishes several model portfolios that investors can purchase as a basket. These baskets may be sector or broader-based portfolios. Alternatively, investors can custom-design their own portfolios. In either case, investors can trade these portfolios with the sponsor just as though it were a personalized mutual fund. The advantage of this arrangement is that, as is true of ETFs, the individual investor is fully in charge of the timing of purchases and sales of securities. In contrast to mutual funds, the investor’s tax liability is unaffected by the redemption activity of other investors. (Remember that in the case of mutual funds, redemptions can trigger the realization of capital gains that are passed through to all shareholders.) Of course, investors would similarly control their tax position using a typical brokerage account, but these basket accounts allow one to trade ready-made diversified portfolios. Investors typically pay an annual fee to participate in these plans.
Read More: EXCHANGE-TRADED FUNDS - ETFs
